THE INSTITUTIONAL FOUNDATIONS

OF AL QAIDA’S

GLOBAL FINANCIAL SYSTEM

MATTHIAS SCHRAMM1 and MARKUS TAUBE2 University of Göttingen University of Duisburg

Keywords: Islamic Banking, institutional analysis, transaction cost approach

ABSTRACT

After the terrorist attacks on 9/11 the question was quickly raised how the needed funds

could have transferred into the USA without alarming national security bodies. This article

examines the century-old Islamic hawala-financing system, which was used by al Qaida

group in preparing their attacks. Analysis of the functional principles will show that it is a

highly efficient, extremely robust institutional arrangement for overcoming the risks of op-

portunism. Thus hawala is able to provide an institutional framework to assure enforce-

ment of contracts without relying on any national law. Today, therefore, it is able to ex-

pand independently of existing laws.

1 Dipl. Ök. Matthias Schramm,

Georg-August-Universität Göttingen, Institut für Agrarökonomie, Platz der Göttinger Sieben 5, 37075 Göttingen, Germany, Phone: 0049 (0)551 / 394825 Fax: 0049 (0)551 / 3912122 E-mail: mschramm@uni-uaao.gwdg.de

2 Prof. Dr. Markus Taube Gerhard-Mercator-Universität Duisburg, Institut für internationale und regionale Wirtschaftsbeziehungen, Mühlheimer Str. 212, 47048 Duisburg, Germany Phone: 0049 (0)203 / 3794188 Fax: 0049 (0)203 / 3794157 E-mail: markus.taube@uni-duisburg.de

2

I. INTRODUCTION

The terrorist attacks in September, 2001, focused public attention on a worldwide financial sys-

tem which had, until that point, existed largely out of the public view; that system is known as

hawala. As cooperation among the intelligence agencies of the post-9/11 anti-terrorist alliance

quickly brought to light, the terrorist groups responsible had availed themselves of the centuries-

old hawala system, making it the backbone of their financial structure. But what exactly is ha-

wala, how does it work, and why is it so difficult for investigating offices and enforcement agen-

cies to get grip on this kind of financial dealings?

The following article will explain how hawala works, its historical origins, and its present distri-

bution. In doing so, it will explore the micro-economic rationale and the institutional foundation

behind the hawala financial system, its organization, and its embeddedness in the socio-

economic context of the Islamic religious community.

II. EMPIRICAL EVIDENCES: THE HAWALA FINANCIAL SYSTEM

The hawala financial system has its roots in early medieval commerce in the Near and Middle

East, which contained a multitude of institutional incalculabilities. The economic agents of the

time operated in an environment which was characterized either by the complete absence of for-

mal organization or by formal organization and legal systems which were not sufficiently speci-

fied. Economic interaction was carried out in an environment characterized by the coexistence of

smaller regions shaped primarily by tribal law. These regions were only loosely associated

through Islam. Thus, the transaction radius within which business could be conducted under the

3

protective wing of a single community was comparatively narrow. Any transactions which

reached beyond this radius were encumbered by the constitutional uncertainty inherent in operat-

ing in more than one legal system.3 This problem was ameliorated only by common recognition

of the values of the Koran and shari'a as—at least from a moral perspective—legally binding.4

However, since a barter economy is by nature extremely inflexible, new methods of payment had

to be found.

The search for a new institutional solution to the problem of coordinating economic interac-

tion was decisively influenced by the Koran's directives as to how business was to be conducted.

In particular, the Koran's ban on charging interest—the riba5—continues to shape Islamic finan-

cial dealings to this day.6 This ban on interest forced institutional solutions to be found for the

problem of coordinating economic interaction which differed fundamentally from modern mar-

ket-oriented economic structures; in time an extensive group of institutions came into existence

which are collectively referred to today as Islamic Banking. In medieval commerce, the most

varied types of delayed payment and bills of exchange developed into the most common instru-

3 Compare Schmidt-Trenz, H.-J., 1990. Außenhandel und Territorialität des Rechts: Grundlagen einer neuen

Institutionenökonomik des Außenhandels, 104 Wirtschaftsrecht und Wirtschaftspolitik. Baden Baden, here p. 235.

4 On the special meaning of the underlying social and religious influences at play here and on the proponents of a theoretical Islamic economics compare Gärber, A., 1992. Islam, finanzielle Infrastruktur und wirtschaftliche Entwicklung. Frankfurt, here p. 26.

5 In the Koran riba is denounced as one of the worst sins a faithful Muslim can commit and strictly forbidden. However, the exact definition of riba is problematical: It is unclear whether the ban on riba refers to the levy-ing of interest in general – the usual interpretation – or whether it targets only unreasonably high usurious in-terest. Amereller, F., 1995. Hintergründe des „Islamic Banking“. 71 Schriften zum Internationalen Recht, Ber-lin, here pp. 44-59

6 The rationale that led to the original ban on interest—a institution found in numerous societies, including, for a long time, Christian cultures—originated in the peculiarities of premodern societies, in which no individual could be certain of not at some time being faced with a threat to his or her livelihood and becoming dependent on another's support. Posner, R. A., 1980. A Theory Of Primitive Society, With Special Reference To Law. Journal of Law and Economics 23, 14--15. Given this background, the continuing ban on interest can be interpreted as an atavism of long overcome condi-tions of social coexistence. Naturally, this does not mean that it has not, in the meantime, taken over new func-tions in areas such as signaling and establishing identity. Carr, J. L., Landa, J. T., 1983. The Economics Of Symbols, Clan Names, And Religion. Journal of Legal Studies 12, 153--156 .

4

ments of payment.7 In the end, the hawala system established itself as an efficient institutional

arrangement.8 In its original form, hawala served as a simple delegation of payment or transfer

of a claim;

Person X owes a debt to Person Y, who in turn owes a similar sum to Person Z. In a hawala

transaction, Person Y signs over his claim on Person X to Person Z. For X and Z, there is a

change in the identity of their respective business partners but not in the amount of their ob-

ligation or claim. Y, on the other hand, has balanced his demands and obligations through

this transaction and is therefore eliminated from the economic chain of interaction.

Based on this principle and in light of the fact that a debt transfer of this sort could take place

even when the parties involved were in different locations, from this original interpretation of

hawala there developed over time a complex and geographically limitless network for transfer-

ring sums of money which woes not rely on a preestablished system of positive law. The transfer

of funds within today's hawala financial network takes place according to the principle dia-

grammed in Figure 1.

Figure 1: The hawala financial system

7 Inalcik, H. I., 1969. Capital Formation in the Ottoman Empire. Journal of Economic History 29, 97—140, here

at p. 107. 8 Hawala can be found as a legal concept as early as 1327 in one of the first systematic explications of Islamic

law by the Hanafitic legal scholar Abu Bakr b. Maseud al-Kasani.

5

Locality A Locality BNetwork

Spatial disparity

BC BC

BC

BC BCBC

BC

BC

BC

BC

BCBC

BC

BC

Monetary in- and outflow Monetary in- and outflow

BC = Business client

Potentialcompensation

Financialintermediary

(1)

Financialintermediary

(2)

Note: The spatial disparity mentioned here and in Figures 2 and 3 can refer to two neighboring villages or

two districts in one city, but can equally well take on intercontinental dimensions of thousands of kilome-

ters.

A client who wishes to transfer a certain sum of money meets with the local hawala intermediary

in his village, city or county and tells him the amount of the payment and where and when it is to

take place. The hawala intermediary takes the sum and a small additional handling fee calculated

according to the amount to be transferred and gives the client a code, for example, a simple

word, a short combination of numbers, or a particular verse from the Koran. Then the intermedi-

ary contacts his partner in the relevant target area and tells him the code and the amount to be

6

paid out. In passing on this information, the hawala intermediary in the transaction's place of

origin has completed his part in it. If it has been necessary for him to keep any written record of

the transaction up to this time, it can now be destroyed.9 The client, meanwhile tells the recipient

of the money the code, which can indicate where the payment will be made. The recipient then

goes to the hawala intermediary in the target area (whose identity is also indicated in the code),

pass on the code, and accept payment.

Once the payment has been issued, if not before, the intermediary in the target area destroys

any notes or other indications of the transfer. Most such hawala transactions are concluded

within twenty-four hours leaving no bookkeeping notes or other evidence of the movement of

money. Within the network, the financial intermediaries operate according to the "two-pot" sys-

tem, resorting to a clearing process to balance the sums only if, due to unusually high one-time

payment orders or other structural exceptions,10 it is foreseen that in- and outgoing payments are

not likely to balance each other naturally.11 There is usually no attempt to rectify temporary im-

balances in an intermediary's in- and outflow; instead, partners in the hawala network trust that,

in the middle or long run, the balance will be restored.

Thus, the hawala financial intermediary does not depend on a complicated infrastructure. A

hawala office can be hidden behind the credible façade of, for example, a retail shop, an import-

export business, or even a religious or social institution. At the same time, the business can be

conducted just as easily from a café table or park bench. This explains why it is impossible to

9 The financial intermediary will probably keep a written record of the amount paid to him in order to balance

the in- and outgoing payments and to keep track of his credit or obligation with his counterpart. 10 This would be the case, for example, if the intermediary had his office in a poor area where most of his transac-

tions were payments transferred by relatives working in other countries, such as Pakistani nationals working in the Gulf states.

11 In practice, this clearing process is extremely rare. If it should become necessary, the sums are generally sent by courier in the form of cash or, more likely, jewels, gold or objets d'art. An alternative mechanism is the over- or underinvoicing of regular trade flows (i.e. making use of so called "transfer payments") between offi-cially registered camouflage enterprises. Thus, it is practically impossible for an outsider to connect it to the

7

recognize the financial intermediaries in either the country of origin or the target country of the

transfer as participants in a global financial network.

Considering the lack of transparency inherent in the hawala system, it is understandable that it

has been legally banned in almost all the countries of the world—even those which are strongly

Islamic, such as Pakistan and Iran. The most significant motive for this ban is the fear that ha-

wala's continued existence threatens central government's regulation and control of the nation's

economy since hawala is beyond all of the classical instruments of macroeconomic policy.

A look at the sums of money that are regularly transferred within the network indicates that

such concerns are by no means unfounded. Despite the bans, the volume of financial transactions

in the hawala network at times substantially exceeds that in the formal banking sector. For ex-

ample, Pakistan's finance minister, Shaukat Aziz, estimates that of the six billion U.S. dollars

transferred within Pakistan in the year 2000 only $1.2 billion were moved through the conven-

tional banking system.12 Between the important Islamic countries of Iran, Pakistan, Afghanistan,

and the Arabian Peninsula, in the past few years, some $30 billion have been moved through the

hawala network.13 In India about 50% of economic activity is said to be in some way connected

with the hawala transfer system.14 It is estimated by national and supranational organizations that

every year approximately $200 billion move around the globe through hawala networks without

ever becoming subject to official regulation of any kind.15 Comparing transactions of these di-

mensions with the $200,000 that have been estimated as necessary to prepare and carry out the

earlier financial transaction.

12 Compare: 2001a. Cheap and Trusted. Economist, Nov. 24, p. 77. 13 Compare: 2001b. Im Untergrund verirrt, Spiegel-Online,

http://www.spiegel.de/wirtschaft/0,1518,166161,00.html, visited November 5, 2001. 14 Stern, B., 2001. Trois grands systèmes parallèles de fonds ont été identifiés. Le Monde, 2 October, 4. 15 Compare 2001c. hawala, in Fachinformationsdienst intern.de, http://www.intern.de/news/2171.html, visited

November 8, 2001.

8

devastating attacks in New York and Washington16 makes it clear that hawala networks have no

problem at all moving the moneys required to maintain international terrorism.

III. AN MICROECONOMIC ANALYSIS OF HAWALA

Hawala networks can be seen as the product of evolution, as institutions that contributed to the

further lowering of transaction costs in an economy with an already highly complex division of

labor, thus enabling complex exchange relationships—especially in interregional and interna-

tional commerce. Their ability to provide a mechanism for safeguarding transactions in an envi-

ronment insufficiently regulated by law is just as relevant today as it was in the early middle

ages. The hawala financial institution of today has continued to develop and adapt to current

conditions, which are dramatically different.

A. Overview

The coordination problem solved by hawala can be seen—for both the historical and the present-

day forms of the system—as the lack of a impartial third party who could oversee the fulfillment

of the contractual arrangement on behalf of each of the interested parties.17 The individual eco-

nomic parties are thus forced to develop an institutional arrangement which makes it possible to

ensure the fulfillment of their respective contractual obligations. This requires a situation in

which each party involved in the transaction has a personal interest in the contract being fulfilled

16 In the opinion of FBI experts on terrorism, this is the maximum amount necessary for the terrorists to have

traveled to the United States and remained there for at least one year while receiving flight instruction. Com-pare 2001d. Auf der Suche nach Bin Ladins Geld, Frankfurter Allgemeine Zeitung, September 26, pp. 1--2.

17 Whereas, in the early middle ages, the need resulted from the lack of formal regulatory mechanisms, today it continues because of the ban on hawala that exists in most nations. The actors who use hawala today are there-fore acting outside the civil law in the countries in which they conduct their financial business. Therefore, they have no recourse to any protective entity which could enforce the contracts they have entered into. Naturally, this applies particularly to extremist terrorist groups who make use of hawala banking to finance their activi-ties.

9

and considers a long-term continuation of the business relationship more useful than its oppor-

tunistic termination.18 The need for this is clear, as it can be assumed that the (at least to some

extent) rational economic parties, who are seeking to maximize their profits, will terminate con-

tractual relationships when they anticipate that doing so will bring them greater benefit.19

From the perspective of the new institutional economics, this problem can be solved either

through a relational contract on the basis of a horizontal interaction pattern or through the trans-

fer of a transactional relationship in a hierarchical regulatory system.20 Hawala networks repre-

sent a solution to the coordination problem based on chains of relational contracts coordinated by

its various financial agents. These contractual chains, which are depicted in Figure 2, enable the

intervention of financial intermediaries to break down a direct transaction between the economic

parties (a) and (b) which would be encumbered by prohibitively high transaction costs and risks

into a series of transactions, whereby transaction costs and risks are reduced to a level which

does not impede completion.

Figure 2: The Web of Relational Contracts in hawala

18 Compare Telser, L. G., 1980. A Theory of Self-enforcing Agreements, Journal of Business 53, 27—44, here at

p. 43. 19 As Telser notes, “a party […] calculates whether his gain from violating the agreement is greater or less than

the loss of future net benefits that he would incur as a result of detection of his violation and the consequent termination of the agreement by the other party. If the violator gains more than he loses from the violation, then he will violate the agreement." Telser, supra note 18.

20 In addition to these two coordination mechanisms, the NIE considers the market a third elemental regulator in economic processes based on the division of labor. (Compare: Williamson, O. E., 1979. Transaction Cost Eco-nomics: The Governance of Contractual Relations. Journal of Law and Economics 22, 233--261, here at p. 248) In market-coordinated transactions, when money is short, the partners avoid investing in complex struc-tures intended to minimize the risk of opportunism by their counterparts. To do this is possible only if the transaction takes place under the protective wing of a general societal consensus which particularly protects the property rights of the partners, either through informal rules of behavior or formal, institutionalized regula-tions. Market-coordinated relationships are therefore only suitable for the coordination of transactions as long as there is an externally imposed regulatory framework and, accordingly, cannot contribute to the regulation of tribal or cross-border transactions.

10

Locality A Locality BNetwork

Spatial disparity

Financialintermediary

(1)

Financialintermediary

(2)

Relationalcontract

(1)

Relationalcontract

(2)

Relational contract (3)

Businessclient

(a)

Businessclient

(b)Intended Transaction

As shown in Figure 2, there are two basic forms of transaction relationship in a hawala contrac-

tual arrangement: The core transaction (relational contract [3]) between the financial agents and

the peripheral transactions (relational contracts [1] and [2]) between the individual agents and

their clients. These two types of transaction are subject to various coordination mechanisms, as

will be more closely examined below. But first, the regulatory principles of the core transactions,

which form the basis of the hawala financial system, will be investigated.

B. Cooperation within the Core Transaction

11

Within the hawala core transaction cooperative behavior is guaranteed through the establishment

of a special informal organization which permeates the entire business relationship.21

Hawala networks can be seen as homogeneous clubs22 which guarantee their members

the enforceability of available property rights in an institutionally disorderly environment

as well as lower transaction costs (in the form of setup and various other management

costs).23 The hawala network establishes legal safeguards for its members in the disposition

of property rights within the framework of economic transactions24 in that it embeds one-

shot games (one-time-only transactions between isolated economic parties), which are sub-

ject to opportunism, in an iterative system of multiple games (transactions with other club

members).25 Thus in an environment missing the provision of the public good contrac-

tual/legal security hawala-networks provide a club good solution to this problem. Finally,

the system also ensures that people keep faith with their contractual obligations because of

the rapid spread of information through the network as to who is trustworthy and who is

not.26 Trustworthy, cooperative behavior is rewarded by the continuing ability to carry out

low-cost transactions with the network members. Opportunism, on the other hand, is pun-

21 Williamson, O. E., 1985. The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting.

London, at p. 72 and 90. 22 Compare Buchanan, J. M., 1965. An Economic Theory of Clubs. Economica 32, 1--14. 23 Such financial systems based on homogeneous clubs are also developed in other cultures in response to similar

problems. In China during the Tang Dynasty (618-907 A.D.) an interregional payment system known as fei qian (flying money) was practiced for purposes of tax payment or commerce between provinces far removed from one another. Moreover, it is known that, in the medieval commercial center of Bruges, payments among businessman were directed through a network of moneychanger, which follows the same inherent structure and principles as the hawala system. Roover, R. de, 1942. Banking, and Credit in Medieval Bruges. Journal of Economic History 2, 52--65, here at p. 62.

24 In this context, the club, in accordance with Sandler, becomes a "nongovernmental alternative to the optimal provision of a class of public goods.“ Sandler, T., Tschirhart, J., 1997. Club Theory: Thirty years later, Public Choice 93, 335--355, here at p. 336.

25 Compare Axelrod, R., 1983. The Evolution of Cooperation. New York, which shows that cooperative behavior becomes the dominant strategie only in an iterative play and can resolve the prisoner's dilemma.

26 Goudie, A. W., Stasavage, D., 1998. A framework for the analysis of corruption. Crime, Law and Social Change 29, 113--159, here p. 135.

12

ished by the withdrawal of goodwill or even expulsion from the network.27 Thus, the af-

fected party suffers not only the loss of the investment necessary to join the network, but

also a massive rise in the cost of future transactions28 —in some cases at such a prohibi-

tively high level that it may mean complete withdrawal from his field of operation with an

implicit threat to his livelihood.29 Thus, "performance is implicitly enforced by the threat of

termination of the transactional relationship and communication of the contractual failure

to the marketplace."30 When this happens to one of the network members, it serves as a

warning to the rest. Since the possible consequences of contractual failure are demon-

strated so drastically, interest in opportunism is discouraged, and, thereby, general adher-

ence to both formal and informal rules ensured.31 Such punishments are also useful in that

they convince the members of the credibility of the threat of punitive action; only credible

threats of punitive action will function effectively as a deterrent.32

Determining the optimal size of such a club is central at this point.33 The more members

there are, the harder it becomes to guarantee the ubiquitous enforcement of sanctions

against infringements. If the optimal club size is exceeded, it increases the cost to the

27 For documentation of similarly constructed punitive practices in Chinese Guanxi networks of varying severity,

see: Wank, D. L., 1999. Producing Property Rights: Strategies, Networks, and Efficiency in Urban China’s Nonstate Firms, in: Oi, J., Walder A. (Eds.), Property Rights and Economic Reform in China, Stanford, pp. 248--272, here at p. 265.

28 Kranton, R. E., 1996. Reciprocal Exchange: A Self-Sustaining System. American Economic Review 86, 830--851, here pp. 831, 845.

29 As Buskens has determined, “Sanctions in social networks can go even further than the termination of business relationships with a trustee who has abused trust. […] untrustworthy merchants can fall victim to social ostra-cism and lose all social and religious contacts. This sanction is so severe that, in this type of society, trust be-comes almost self-evident and sanctions are hardly ever necessary.” Buskens, V., 1999. Social Networks and Trust. Utrecht, here p. 18.

30 Klein, B., 1985. Self-Enforcing Contracts. Journal of Institutional and Theoretical Economics (Zeitschrift für die gesamte Staatswissenschaft) 141, 594--600, here p. 595.

31 Compare Schmidt-Trenz, supra note 3, at 284. 32 Dasgupta, P., 1988. Trust as a Commodity. in: Gambetta, D. (Ed.), Trust: making and breaking cooperative

relations, New York, Oxford, pp. 49--72, at p. 50. 33 Compare Buchanan, supra note 22 (1965): pp. 3.

13

members of information concerning infringements by individuals,34 and the punishment of

bad faith can no longer always be guaranteed. In the case of hawala networks, the standing

conferred by club membership and the initial investment required to join are both so

high—as will be more closely described below—that crowding effects, for all intents and

purposes, cannot occur.

This leads to a situation in which, for the most part, the increasing advantages of maintaining

a long-term business relationship significantly outweigh any short-term profit which might result

from an opportunistic breach of contract. Therefore, the network members behave in accordance

with their contractual obligations.

Nevertheless, more than the purely economic incentive (low transaction costs) is needed to

prompt the formation of such homogeneous clubs as hawala networks. In addition to economic

factors, club membership must also endow the individual with a certain identity and reputation.

Only in this way is it possible for trust to be established between the individual partners in a

transaction, thus alleviating the uncertainty inherent in "faceless" transactions of this kind. This

trust can be translated into secured expectations35 only if the relevant transaction partner has been

identified as a fellow club member.

Especially credible signals of trustworthiness are provided by ethical and religious identify-

ing features.36 Timur Kuran shows that

34 Compare Carr; Landa, supra note 6, at 139-142. 35 Dasgupta, supra note 32, at 50. 36 Not least for this reason, today, despite extensive secularization, the importance of religion in social and, with

it, economic matters is taking on increasing importance (Compare Iannaccone, L. R., 1998. Introduction to the Economics of Religion, Journal of Economic Literature 36, 1465—1496, here at p. 1466 ), and, "if a religious organization has its members spread throughout the world, economic advantages will occur to its members both in local and international trade.“ Carr; Landa, supra note 6, at 152.

14

"[a] factor that has fueled economic Islamization is that an Islamic subeconomy helps its

participants cope with the prevailing adversities by fostering interpersonal trust. […]

Their shared commitment to Islam, even if partly feigned, keeps many of their activities

within social circles in which information about dishonest behavior spreads quickly, thus

providing a basis for mutual trust.“37

Extremist groups like Al Qaida and the Taliban are especially suited to the formation of homo-

geneous clubs through their religious creeds and ideologies, since

"we should not expect the dominant religious organization in an area to form the basis of a trad-

ing group. If membership in a religious group is very large, the religious group may be far in ex-

cess of the optimal size for economic purposes. Too large a group may imply too small an ability

to impose sanctions on those who breach contracts. If this is the case, preferential treatment will

be given to fellow coreligionists.”38

Examining the hawala networks in this light, one's attention is drawn to their strict adherence to

Islamic law. Shari'a claims to represent a supranational code of law.39 Therefore, in theory it can

serve to secure transactions that go beyond "secular" legal jurisdictions, so that the regulatory

problem which prompted the development of hawala networks in the first place should actually

never have occurred at all. In practice, however, shari'a was and is handicapped in this role be-

cause, firstly, there is no supranational judiciary and executive to enforce it and, secondly, its

validity is not recognized by all economic entities. Thus, in spite of its claim of universal valid-

ity, shari'a can only take on regulatory functions in religious "islands" where the community

37 Kuran, T., 1995. Islamic Economics and the Islamic Subeconomy. Journal of Economic Perspective 9, 155--

173, here at p. 168. 38 Carr; Landa, supra note 6, at 152. 39 "[T]here is no separate discipline which is entitled Islamic International Law or which has in its title the

word 'international‘ altogether. What Islam has is Islamic Shari’a law which deals with every aspect of every possible human conduct regardless of its description as an internal/municipal or international conduct.“ Zahraa, M., 2000. Characteristic Features of Islamic Law: Perceptions and Misconceptions. Arab Law Quarterly 15, 168--196, here at p. 170.

15

recognizes its validity and enforces its legal principles. But since there are such religious com-

munities, or at least members of them, scattered around the globe, shari'a continues to function

as a rival to the mostly state-run legal systems of the world.

Against this background, at least a number of the hawala financial networks in existence—

most probably including some run by Al-Qaida terrorist groups—are clubs which look to the Ko-

ran for their guiding principles and establish shari'a as the law for their members and execute it.

Accordingly, Al-Qaida may be seen as a Mafia-like organization which takes over governmental

functions inasmuch as it administers justice in an area in which the formal justice system is con-

sidered by definition to have no jurisdiction.40 The basic characteristic in such a club that makes

possible the identification of members and the development of trust between them would thus be

mutual recognition of shari'a or identification with common religious principles and values.41

Connected with this is the willingness to subject oneself to an automatic mechanism of sanctions

with the threat of excessive punishment, whereby one's credibility as a trustworthy business

partner is convincingly signaled within the religious community.

The attempts described above to establish and preserve one's reputation as a trustworthy club

member can be seen as (specific42) investments in social capital.43 In other words, the share

capital in clubs like hawala networks is composed of accumulated social capital. This stabilizes

40 Compare Anderson, A., 1995. Organised Crime, mafia and governments. in: Fiorentini, G., Peltzman, S. (Eds.)

The economics of organised crime, Cambridge, pp. 33--54, here at p. 34. 41 These can also comprise the refusal of secularly oriented Western social regulations, which, are perceived to be

hedonistic and, due to their economic and technological competitiveness, a threat to the Islamic identity. In the context of Al Qaida terrorist groups, this aspect of a common ideology takes on particular significance, since, as Skaperdas und Syropoulos show "the long-rung success of gangs and primitive states depends heavily on the articulation and internalization by members, subjects and community of a workable ideology, a logically con-nected system of beliefs about the world.“ Skaperdas, S., Syropoulos, C., 1995. Gangs as primitive states. in: Fiorentini G., Peltzman, S. (Eds.) The economics of organised crime, Cambridge, pp. 61--82, here at p. 75.

42 On the concept of asset specificity Compare Williamson, supra note 20,at 52. 43 Compare Dasgupta, P., Serageldin, I., 1999. Social Capital. A Multifaceted Perspective, Washington.

16

the existence of the clubs in that it takes on the characteristics of sunk cost.44 Any club member

who were to be expelled from the club would irrevocably lose his social capital expenditures.

Each member therefore has strong material incentives to behave in accordance with club statutes,

not only in order to enjoy the returns on his investments but also to avoid the complete write-off

of his invested capital.

However, investment in the social capital of a hawala network must also be seen from another

perspective as a specific investment in Williamson's sense. The fact that the nature of hawala

networks is at least to some extent religious renders the diversification of investments in social

capital and with it the reduction of social risks impossible: The tie to a religious system of the

radical nature described (and assumed) here is much the same as a high, specific investment that

prevents (social) transactions with other religious or social groups from ever taking place. In

other words, the choice of membership in such a club—and with it the construction and bond of

social capital— is not only final but also exclusive. Diversification of transaction potential and,

with it, risk reduction is not possible.45 At the same time, however, the decision to join this kind

of club is irreversible (indeed, bringing with it a potential threat to one's livelihood), so that the

decision itself can be interpreted as a reliable and credible signal to other club members of one's

trustworthiness.46 After all, the punitive power of the club cannot be circumvented by substitut-

ing transactions carried out in alternative systems for the transactions with club members lost

through opportunism.

44 Because investments in club-specific social capital take on the characteristics of sunk cost, they enter the calcu-

lation of the individual business clients as fixed costs. This block of comparatively high fixed costs contrasts with the low, variable transaction fees in the club society of the hawala network, where, with reduced club membership, further costly mechanisms to secure transactions and reduce risks can be dispensed with. The low level of variable fees produces an incentive for using the network as intensively as possible, since each addi-tional transaction reduces the average costs for all transactions carried out in the hawala network.

45 On the basic concepts of Portfolio Selection Theory compare Markowitz, H. M., 1965. Portfolio selection: effi-cient diversification of investment. New York.

46 Compare Williamson, O. E., 1983. Credible Commitments: Using Hostages to Support Exchange, American

17

C. Cooperation in Peripheral Transactions

Like core transactions, peripheral transactions, which are necessary for the development of the

network of hawala intermediaries into a functioning financial system, must be subject to a secu-

rity mechanism which prevents opportunism and ensures the fulfillment of contractual obliga-

tions.

Enforcement of the relational contracts between clients and hawala financial intermediaries

(cf. Fig. 2) can only be guaranteed through an informal institutional arrangement since both par-

ties are operating outside the national (or regional) justice system. Hawala has been banned al-

most everywhere, as explained above, so the parties have no recourse to a codified institutional

framework which would ensure the fulfillment of contractual obligations.

On the level of peripheral transactions, there are three basic forms opportunism might take:

1) FI (1) accepts a sum of money from BC (a), but does not instruct FI (2) to make pay-

ment to BC (b) or instructs FI (2) to make payment to BC (b) in a lesser amount than

agreed upon with BC (a).

2) FI (2) pays BC (b) a lesser amount, claiming (falsely) that it is the amount he has

been instructed to pay.

3) BC (a) falsely claims to BC (b) that he paid a higher amount to FI (1) than was ulti-

mately paid out to BC (b), thus attempting to pass on the blame for his own mistake

to FI (1) or FI (2).

Economic Review 73, 519--540, here at p. 521.

18

At first sight, opportunism of this sort appears to be made possible by the distinctive informa-

tion asymmetries: In a hawala transaction, over a relatively long period of time a potential in-

formation deficit develops to the detriment of the client, since he must first rely on the interme-

diary to fulfill his task. However, in the evolution of hawala networks particular solutions have

been developed to resolve such problems. These solutions which counteract institutional incalcu-

labilities and can decrease information deficits. Thus, there is inherent protection against possible

information asymmetries because of the sophisticated communication system within the hawala

financial network,47 as shown in Figure 3.

47 Compare on the structure of communication systems to reduce information asymmetries in medieval interre-

gional commerce also: Greif, A., 1989. Reputation and Coalition in Medieval Trade: Evidence on the Maghribi Trades. Journal of Economic History 49, 857--882, here at p. 879.

19

Figure 3: Information flow and individual transactions in hawala banking

Locality A Locality BNetwork

Spatial disparity

Financialintermediary

(1)

Financialintermediary

(2)

Businessclient

(b)

Cod

e

Tran

sfer

of

fund

s

Paym

ent

orde

r

Cod

e

Tran

sfer

of

fund

s

Businessclient

(a)

Code

Code

Originally intended transfer

As pictured, the client (BC [a]) places an order with his financial intermediary (FI [1]) for the

payment of a certain sum of money and gives him that amount plus the negotiated transaction

fee. The hawala intermediary provides the client with a specific code, which the client must then

pass on to the recipient of the money in the target area (BC [b]). The intermediary in the network

hub where the payment is to be issued (FI [2]) also receives the code—both from his partner in

the network and from business client (b). At this point, the circle of communication within the

hawala network has been perfectly completed: Both business client (a), who has initiated the

payment order, and business client (b), the recipient of the payment, know the sum to be trans-

20

ferred, so that neither FI (1) nor FI (2) has any informational leeway. Moreover, feedback is pos-

sible at all times on both levels—that of the clients and that of the financial intermediaries. The

transaction between the financial intermediaries is safeguarded through the arrangements imma-

nent in the network, as described in the preceding section. Should unintentional information

asymmetries occur between the clients,48 one can still assume that the information exchanged

within the hawala network is roughly homogeneous.49

Nevertheless, even if the information asymmetry in the hawala system has been alleviated,

from the point of view of the new institutional economics, in a situation of high institutional un-

certainty such as this, the risk of opportunism continues to exist.50 By handing over his money,

the client in a hawala transaction is exposing himself to the risk of a hold-up by the financial in-

termediary, who, in the short-run of the unique transaction, needs fear no consequences from the

opportunistic breach of contract.51 However, there are recognizable safeguards on the level of the

peripheral transaction which are capable of limiting such opportunism.52 Here the reputation of

48 That is to say, we rule out opportunism of type (3) in peripheral transactions. The plausibility of this assump-

tion will be explained below. 49 In a similar context, Greif shows that, in accordance with the theory of repeated games with imperfect monitor-

ing, a multilateral punishment strategy in a network can enforce compliance with a contract even if its execu-tion is not perfectly monitored. See Greif, A., 1993. Contract Enforceability and Economic Institutions in Early Trade: The Maghribi Traders´ Coalition. American Economic Review 83, 525--548, here at p. 531.

50 Compare Husted, who shows that, in the case of corrupt transactions, if "transactions occur outside the law, there are many opportunities for the parties to take advantage of each other.” Bryan Husted, B., 1994. Honor Among Thieves: A Transaction-Cost Interpretation Of Corruption In Third World Countries. Business Ethics Quarterly 4, 17--27, here at p. 19.

51 It should not be overlooked at this point that the hawala intermediary is himself subject to a "hold-up" by his client. Even though there is hardly any record of the transaction which might be used against him, the client, with his first-hand knowledge of the proceedings, could report the intermediary to the authorities.

52 In addition to the safeguards described here, it could also be argued that the mere existence of the hawala net-work is enough to prevent opportunism between the financial intermediaries and their customers—although the latter transactions do not fall directly within the secured sphere of network operations—since, if a financial in-termediary were to indulge in opportunism (see types [1] and [2] listed above), he would automatically be dis-credited. Such damage to the business partner's integrity and reputation could be interpreted as a violation of the hawala behavior code and thus activate club sanctions.

21

the individual financial intermediary plays a particular role. Reputation, understood in the sense

that it "emerge[s] if an actor's future partners are informed on his present behavior,"53

can function as a credible signal of his trustworthiness to potential customers.54 At this point, the

special Islamic underpinning of the hawala financial system in general and the hawala networks

in particular takes on significance: Belonging to a network of this sort involves, as described

above, high specific investments. These investments not only establish a foundation of social

capital within the network, but also serve to build the public reputation of the individual financial

intermediary. The tie to the religious system of sanctions implemented by hawala networks on

the basis of shari'a can be interpreted by the relevant small social groups of (potential) clients as

credible evidence (signal) of trustworthiness.55 At the same time the construction of reputation

also leads to a rise in the costs of opportunism in that it raises the actor's visibility (prominence)

in the social group. Thus,

"reputation effects enlarge the long-run costs of exploitation; these long-run costs become

greater the faster an actor’s reputation spreads in his interaction network. In this way, mu-

tual abstention from attempts to exploit partners, based on conditional cooperation, can

become individually profitable.”56

53 Raub, W., Weesie, J., 1990. Reputation and Efficiency in Social Interactions: An Example of Network Effects.

American Journal of Sociology 96, 626--654, here at p. 626. 54 Closely associated with the reputation of the actors is the fact that peripheral transactions do not take place in

the facelessness of anonymous business relationships; instead, everyone involved can be identified. Ben-Porath points out the particular importance of the identity of the partners in transactions which are characterized by a lack institutional security. In such a context, the mutual identification of the partners can prevent market failure and encourage lower transaction fees. Compare Ben-Porath, Y., 1980. The F-Connection: Families, Friends, and Firms and the Organization of Exchange. Population and Development Review 6, 1--30, here at p. 5.

55 An example of the importance of reputation in carrying out transactions in small groups is given by Colemann in his study of Jewish diamond dealers in New York City: „A given merchant community is ordinarily very close, both [sic] in the frequency of interaction and in ethnic and family ties. [...] It is essentially a close com-munity. […] [T]hese close ties, through family, community, and religious affiliation, provide the insurance that is necessary to facilitate the transaction in the market. If any member of this community defects…he would lose family, religious, and community ties.“ Coleman, J., 1988. Social Capital in the Creation of Human Capi-

22

It must also be noted that simply being a member of a hawala network generates no pay-off from

the latent social capital. It is the integration of these investments in the peripheral relationships of

the system that make it possible to obtain a pay-off. However, that makes it necessary for the in-

dividual hawala intermediary to carry out as many transactions as possible in his social environ-

ment. In an iterative game it is possible for both sides to punish opportunism; thus, cooperation

and compliance with contractual obligations becomes the dominant strategy.57

Furthermore, because of their strongly ideological embedding in the social context, such

transactions often take place only within very small groups. The likelihood that clients and fi-

nancial intermediaries will meet again and opportunism will be punished is therefore extraordi-

narily high. The fact that the hawala intermediary is usually an important part of the social

community (within a village or a region, for example) is enough on its own to prevent opportun-

ism.

This social embeddedness58 of the institutional structure of the hawala financial system in the

Islamic social hierarchy is a further functionally significant factor. In the context of the entire

social system, neither the selection nor the organization of formal or informal institutions takes

place solely on the basis of economic criteria of efficiency; both are also subject to cultural and

social-religious influences.59 As Uzzi notes,

tal. American Journal of Sociology 94, 95--120, here at p. 99.

56 Raub; Weesie, supra note 53, at 647. 57 Axelrod, supra note 25. 58 Compare Granovetter, M., 1985. Economic Action and Social Structure: the Problem of Embeddedness.

American Journal of Sociology 91, 481--510. 59 Paul DiMaggio, P., 1994. Culture and Economy, in: Smelser, N., Swedberg, R. (Eds.) The Handbook of Eco-

nomic Sociology, Princeton, pp. 21--57, here at 38.

23

"embeddedness is a logic of exchange that shapes motives and expectations and promotes coordi-

nated adaptation. This logic is unique in that actors do not selfishly pursue immediate gains, but

concentrate on cultivating long-term cooperative relationships”60

The entire Islamic banking and financial world is particularly subject to this social embedding.

The special conditions and limitations governing Islamic banks do not result from economic ne-

cessity—on the contrary, from that point of view, they are hard to defend—but rather from a

comprehensive religious understanding.61 As an informal institution which resulted from an evo-

lutionary process, the hawala financial system can therefore be considered significantly more

strongly interwoven with the social-religious fabric of society. This, however, means that the in-

formal safeguards described above as well as the norms and values affiliated with the entire sys-

tem may gain a self-reinforcing element due to their particular embeddedness.

From the previous discussion, it can be deduced that it serves the self-interest of FI (1) and (2)

to avoid opportunistic treatment of their clients, BC (a) and (b). At the same time, the third po-

tential form of opportunism in the context of peripheral transactions also becomes unavailable.

Since one can assume with a confidence bordering on certainty that the financial intermediaries

will not engage in opportunism with regard to the relational contracts (1), (2), and (3), a false

assertion from BC (a) to BC (b) would immediately be exposed as dishonest. Since such an at-

tempt would obviously fail on this level as well, it simply will never occur in the first place.

60 Uzzi, B., 1996. The Sources and Consequences of Embeddedness for the Economic Performance of Organiza-

tions: The Network Effect. American Sociological Review 61, 674--698, here at p. 693. 61 Compare Kuran, T., 1996. The Discontents of Islamic Economic Morality. American Economic Review 86,

438—442, here at p. 438.

24

IV. CONCLUSION

Analysis of the functional principles of the Islamic hawala financial system has shown that it is a

highly efficient, extremely robust institutional arrangement for overcoming the risks of opportun-

ism among the partners in a transaction. It is an institution which was developed over the course

of centuries against the backdrop of a lack of formal regulatory systems and which today, there-

fore, is able to expand freely outside and independently of existing regulations.

The central regulatory principle of the hawala financial system comprises chains of relational

contacts which break down basic business dealings that would otherwise be encumbered by pro-

hibitively high risks into several individual transactions, the risks and transaction costs of which

have been reduced to such a degree that it becomes possible to carry them out. Within this chain

of relational contracts it is possible to distinguish various regulatory mechanisms for the core and

peripheral transactions.

In the area of core transactions, the problem of regulation is solved through the formation of

homogeneous clubs. These clubs—the hawala networks—create lock-in situations through

which extremely risk-laden exchange relationships can be transformed into self-fulfilling con-

tracts. Through the high expenditure of investment in social capital that accompanies member-

ship, all parties provide credible documentation of their commitment. Their investment will only

return a profit if future transactions are carried out in the interests of all the contractual partners.

Due to their high stock of sunk capital, hawala networks create governance structures analogous

to vertical integration solutions which force the transaction partners to abide by the contract.62

62 Thus they approximate the ideal microeconomic solution to the problem of coordination. Compare Reja, B.,

Talvitie, A., 2000. The Industrial Organization of Corruption: What is the Difference in Corruption Between Asia and Africa, paper presented at The Annual Conference 2000 of the International Society for New Institu-tional Economics, Tübingen, September 2000, at pp. 5-8.

25

The trustworthiness of club members results from secure expectations about their rational, pur-

pose-oriented behavior.

Removed from economic calculation, the common Islamic creed plays a central role in the

development and long-term existence of hawala networks. It defines a set of values shared by all

club members which provides stability for the network not only on the economic-material level

of maximizing profits, but also on the religious-ideological level. On this level, through the dis-

semination of fundamentalist and anti-Western ideologies, extremist groups like Al Qaida and

the Taliban are able to set very specific accents in forming club identities which, because of their

radicality, are particularly effective in stabilizing such club communities.

Peripheral transactions are safeguarded by the prevention of information asymmetries, effects

on reputation, and the high degree of probability in small social groups that dishonesty will be

punished. The embeddedness of the transaction activity in the Islamic religious community se-

cures the transaction even more effectively than purely rational economic calculation.

On the whole, it is clear that hawala financial systems are capable of providing a complete

transaction infrastructure within which the business partners can protect themselves from ex post

opportunism by any one party. The ability to provide informal mechanisms for safeguarding

transactions outside the jurisdiction of national regulations makes it possible to conduct just

about any transaction on the supranational level. This and the "invisibility" of hawala financial

intermediaries, who can conceal their activities behind the façade of legal businesses, really do

make the hawala financial system the optimal organizational form for terrorist groups like Al

Qaida, who need an efficient financial infrastructure to support their global activities. In addition,

the fact that the anyway minimalistic documentation of hawala transfers is usually completely

26

destroyed once the transfer has been executed satisfies these terrorist groups' request for not only

confidential but also "traceless" financial transactions.

The global anti-terrorist alliance, who have made it their goal to bring to justice the terrorist

groups responsible for the mass murder on 9/11 and to prevent further acts of terrorism, are

likely to find it difficult indeed to shut down the financial infrastructure of criminal groups like

Al Qaida.63 While those financial transactions carried out through the formal banking system can

be discovered and stopped comparatively easily64, a second, informally organized financial infra-

structure will continue to exist in the hawala financial system. This system has not only handled

the majority of financial transactions for terrorist groups up until now, but it is also in the posi-

tion to absorb those monetary flows which are being pushed out of the formal banking system.

However, because of its specific institutional structure, the hawala financial system is well-

prepared to elude surveillance and regulation by anti-terrorist units. Already in 1994 the US-

congress passed a law forcing all hawala intermediaries doing business in the USA to register.

However, how they should be encouraged to freely expose themselves to the government was

not stipulated within the regulation. Thus, it was never used by investigating offices. The ex-

treme sanctions imposed on those practicing hawala which have long existed in Islamic coun-

tries have posed no threat to the system's continued existence, either. Moreover, it is question-

able, considering the informal organization of hawala networks, whether there are any imagin-

able restrictions which could force its individual members—in light of their high specific in-

63 Cf. FitzGerald, V., 2002. Global Financial Information, Compliance Incentives and Conflict Funding. paper

presented to the DIW workshop 'The Economic Consequences of Global Terrorism', Berlin 14-15 June 2002, pp. 12-19.

64 A sum of nearly 50 Mio $ on accounts owned by 150 persons and organizations in over 40 countries was freezed shortly after the 9/11 attacks. For some of the many intricacies still involved in tracking 'terror money' in the formal financial system see: FitzGerals (2002) supra note 63; and Schneider, F., 2002. Money Supply for Terrorism – The hidden financial flows of Islamic terrorist organisations: Some preliminary results from an economic perspective. paper presented to the DIW workshop 'The Economic Consequences of Global Terror-ism', Berlin 14-15 June 2002.

27

vestments—to give up their involvement in the system. The most likely tactic would be to influ-

ence the cost-profit calculation of the customer of the hawala financial system—because of by

tightening controls or by providing alternatives; customers are seldom integrated into the broad

networks, but use hawala only as a low-cost (and ideological) alternative to the formal banking

system. Without these "small" customers, however, the functional capability of the system would

be reduced since without them it would be difficult to maintain balanced accounts.

Lastly, it can be assumed that, in spite of the initial military successes of the anti-terrorist alli-

ance in Afghanistan, Al Qaida's (financial) ability to act has hardly been reduced at all. The in-

ternal construction of their institutional basis as depicted here would, rather, lead one to believe

that Al Qaida will be able to reestablish itself quickly in new territories.

28

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31

Figures

Figure 1: The hawala financial system

Locality A Locality BNetwork

Spatial disparity

BC BC

BC

BC BCBC

BC

BC

BC

BC

BCBC

BC

BC

Monetary in- and outflow Monetary in- and outflow

BC = Business client

Potentialcompensation

Financialintermediary

(1)

Financialintermediary

(2)

Note: The spatial disparity mentioned here and in Figures 2 and 3 can refer to two neighboring villages or two

districts in one city, but can equally well take on intercontinental dimensions of thousands of kilometers

32

Figure 2: The Web of Relational Contracts in hawala

Locality A Locality BNetwork

Spatial disparity

Financialintermediary

(1)

Financialintermediary

(2)

Relationalcontract

(1)

Relationalcontract

(2)

Relational contract (3)

Businessclient

(a)

Businessclient

(b)Intended Transaction

33

Figure 3: Information flow and individual transactions in hawala banking

Locality A Locality BNetwork

Spatial disparity

Financialintermediary

(1)

Financialintermediary

(2)

Businessclient

(b)

Cod

e

Tran

sfer

of

fund

s

Paym

ent

orde

r

Cod

e

Tran

sfer

of

fund

sBusiness

client(a)

Code

Code

Originally intended transfer